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Regulatory Responses to Investor Irrationality: The Case of the Research Analyst

An extensive body of behavioral economics literature suggests that investors do not behave with perfect rationality. Instead, investors are subject to a variety of biases that may cause them to react inappropriately to information. The policy challenge posed by this observation is to identify the appropriate response to investor irrationality. In particular, should regulators attempt to protect investors from bad investment decisions that may be the result of irrational behavior?

This article considers the appropriate regulatory response to investor irrationality within the concrete context of the research analyst. Many commentators have argued that analyst conflicts of interest led to biases reports and recommendations that distorted analyst behavior. In the wake of the analyst scandals, regulators have responded - most recently by mandating increased independence. This response can be understood as an effort to make investor reliance reasonable.

The article questions this mission. In particular, the article challenges the role of regulators in identifying appropriate sources of investment information or determining when investor behavior is rational. This fallibility of regulatory oversight coupled with the costs of regulation suggest that regulators should exercise caution, particularly in light of the market's capacity to discipline investor decisions.